Markel: A Buffett Bet

02/04/2005 12:00 am EST


Don Phillips

Managing Director, Morningstar, Inc.

With its wealth of stock and fund analysts under the Morningstar umbrella, the research organization, under Don Phillips, offers not only its well-known fund advice, but excellent stock analysis. Here, analyst Dreyfus Neenan looks at a "Buffett play."

"For years, savvy investors have carefully scrutinized and imitated Waren Buffett's stock investments, figuring that if the maestro likes a stock, they should probably investigate it, too. The executives at Markel (MKL NYSE) have also long admired Buffett's methods, and have modeled their insurance business on Berkshire. Like Buffett, and unlike most insurers, Markel also makes significant equity investments. Vice Chairman Steve Markel and CIO Tom Gayner lead the firm's stock-picking, and we think they have compiled an impressive track record. Over the 13 years ending in 2004, Markel's equity investments appreciated 16.1% annually, far outpacing the S&P 500's 12.1% annual gain. Markel's top notch stock-picking is one reason the firm's equity portfolio has grown from about $100 million at the end of 1994 to more than $1.1 billion today. Few mutual funds can boast better results, and we think investors could learn from studying Markel's approach.

"Gayner outlined Markel's four criteria for selecting equity investments:

  1. Invest only in profitable businesses that earn good returns on capital.
  2. Look for management teams with equal measures of talent and integrity. One without the other is insufficient.
  3. Favor businesses that present opportunities to reinvest capital at high incremental rates of return. As a second preference, invest in businesses that earn high returns on capital and distribute the cash to shareholders. (These are both types of wide-moat businesses.) Avoid businesses that require continual cash injections.
  4. Invest only at a fair price, so that your returns at least match the returns of the business over an extended period. Avoid paying high prices for stocks, no matter how good they are.

"In other words, buy well-managed, wide-moat' businesses at an attractive margin of safety. Music to our ears! However, a quick analysis reveals two further aspects of Markel's stock-picking that we like: a concentrated portfolio and a preference for businesses they understand. Although Markel owns 77 stocks, 56% of the portfolio is invested in the top 10 names, and 72% is in the top 20. And about 45% of the portfolio is invested in insurance stocks, including 12% in Berkshire Hathaway--a business Markel's team understands better than many investors. But perhaps the best illustration we can offer of Markel's buy-at-a-discount philosophy is the portfolio's aggregate average price/fair value ratio; based on Morningstar’s estimates, the fair value of Markel's portfolio is $260 million more than the market price--which we think bodes well for future returns.

"So how might investors profit from studying the Markel approach? Right now, only 6 of Markel’s 77 stocks are cheap enough to earn Morningstar’s 5-star rating. But the way we see it, that's six stock ideas likely to produce attractive long-term returns. And as for the rest, we think they're well worth watching. Here are the favored six: Anheuser-Busch (BUD NYSE) dominates the U.S. beer market. Markel has a long relationship with the team at Fairfax Financial Holdings (FFH NYSE) which was founded after a buyout of Markel's Canadian business in 1985. When they were recently offered the opportunity to invest $100 million in Fairfax stock, Markel snapped it up, immediately making Fairfax their largest stock investment. Important economies of scale in the money management business have made Federated Investors (FII NYSE) a long-term success story. CarMax (KMX NYSE) holds a position as a trustworthy secondhand car dealer is winning it a growing customer base. Also a Buffett favorite, Coca-Cola (KO NYSE) blankets the planet with its widely known beverages. Tribune Company (TRB NYSE) has a portfolio of attractive media assets, including the Chicago Tribune, Los Angeles Times and Chicago's WGN-TV throw off impressive cash flow.

"Of course, you needn't invest in all six stocks to benefit from Markel's stock-picking. A single investment in Markel stock would also yield a stake in the firm's portfolio, but with two added benefits. Rather than waiting for quarterly ownership filings, Markel shareholders benefit from investments at the time they are made. Not only does that provide the same buy price that Markel deemed attractive, it also allows investors to share in the more-favorable terms Markel sometimes accesses as a large institution. Markel shareholders also benefit from the inherent leverage in Markel’s portfolio, plus they receive a stake in one of the US' best-run and most-profitable insurers. And as Markel shares remain one of our best 5-star investment ideas, we think the odds of good returns would be stacked in your favor."

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